July 2019

Inside view: An active manager’s playground

The_Great_Chinese_WallGiven that China’s a global behemoth, its A-shares market deserves more attention, writes Nick Samuels, head of manager research at Redington. The boom in passive investment strategies shows few signs of waning, with active managers – particularly those investing in more mainstream asset classes – increasingly struggling to deliver demonstrable value. There remain, however, good opportunities globally for talented active managers to thrive. In our view, the Chinese A-shares market is among the most compelling. As befits a global powerhouse, China has one of the world’s largest equity markets. Despite its size, potential and the vast opportunities it has to offer, the Chinese A-shares market remains relatively under-researched and under-utilised. This is a common phenomenon in more niche markets and sectors, but is rarely the case in global behemoths such as China. The question is: why have some of its key investment opportunities remained so overlooked? In part, this may be due to the dauntingly chaotic and intemperate nature of the market. It is exceptionally unpredictable, with a volatility of 28% – high when compared to the global average of 16%. Trading volume is huge in comparison to the markets in the UK and Japan, and the deviation between the 300 largest monthly returns is almost twice that of the S&P 500. Much of this can be attributed to the investor base, which is overwhelmingly domestic retail investors (foreign investors only comprise around 2% of the market). This differs markedly from other developed markets, which are largely dominated by institutional investors. However, it is the Chinese market’s volatility and inefficiency that create the conditions for active managers to generate substantial alpha over the long-term. Huge stock dispersion, massive volatility and a large portion of the market behaving sub-optimally are all factors within this. When we visited China on a manager research trip last year, the evidence was clear. We found it was not uncommon for funds to generate levels of alpha that would be considered extraordinary in other markets. However, due to the vast universe of funds (there are over 1,500 mutual funds and tens of thousands of private fund managers) and huge volatility, it is important to tread carefully and identify what may just be investor luck masquerading as skill. The retail-centricity, coupled with China’s fast-growing market, allows inexperienced investors to set up funds easily, and with lots of capital flowing into the market, we saw analysts and portfolio managers with little experience raising material amounts of money. The short-term focus of retail investors also impacts the overall behaviour of the market, making it harder to invest with a long-term horizon. We found it was not unusual to see between 400% and 500% turnover strategies, even with managers who claimed to have a three-year time horizon. Being aware of these characteristics and knowing what you are looking for is more important than ever in areas such as China A-shares. For those who can navigate these factors, though, we believe the market represents a great opportunity for active managers to thrive. The fears and anxieties that drive ebbs and flows are essentially the same as in any other market, but more extreme – the volatility is just an expression of what happens when masses of retail investors own the market. It is the inefficiencies and opportunities this creates that makes the A-shares market an active manager’s dream – but careful fund selection is required to exploit the opportunity. ©2019 funds global asia

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